Market & Topical Perspectives

From Top to Bottom

From Top to Bottom

Undeterred by a range of seemingly unfavorable top-down trends, corporations proved quite resilient in 2023 and many public and private asset classes performed accordingly. Kimball Brooker, co-head of the Global Value team; Jon Dorfman, chief investment officer of Napier Park Global Capital; and Jim Fellows, chief investment officer of First Eagle Alternative Credit, consider this cross-asset conundrum from the bottom up and discuss what current conditions may augur for 2024 and beyond.

Q:
Despite a range of what would seem to be pretty obvious headwinds—including above-target inflation, high interest rates and geopolitical discord—the performance of public and private financial markets was generally positive during 2023. What do you make of this?

Kimball:
I think some of the support we saw in equity markets during 2023 can be attributed to credit market dynamics in recent years. With interest rates at generational lows during the Covid period, many companies extended their debt maturities to lock in these very attractive financing costs for longer, particularly in the US. When the Federal Reserve began hiking its target rate in 2022, the interest income companies could generate on their cash balances followed suit. The end result was a rather unusual phenomenon in which companies in general saw their net interest expenses decline, sometimes significantly, even as prevailing interest rates spiked.1

Jon:
Companies went into this rate-hike cycle with unusually high interest coverage and unusually low net leverage, which meant they were sitting on a lot of cash. This condition, evident among both investment grade and non-investment grade issuers, helped keep the default rate in check even as the cost of capital rose sharply.2 Of course, at some point companies will need to refinance their debt, and I expect those with weaker credit profiles will have some trouble getting attractive terms. Given accommodative maturity walls, however, this likely will play out over the next few years rather than the next few months.

Jim:
I think the relatively forgiving bond maturity schedule Jon references suggests the true pain of higher rates will be first evident in floating-rate paper. We already have felt some initial tremors in the syndicated loan market, even though the default rate remains well below its long-term trend.3 It’s hard to say when the impact of higher rates will reverberate in earnest. Many leveraged-loan borrowers hedge their exposure to interest rate risk through derivative structures like swaps, caps and collars, but few are transparent about their hedging strategy and true exposure. As a result, it’s difficult to ascertain the market’s risk profile as a whole.

Potential recovery rates in the event of default are another important consideration as rates pressure operating performance and constrain liquidity. Though loans historically have had significantly higher recovery rates than high yield bonds due to their seniority in the capital structure, I would not be surprised to see this advantage narrow somewhat during this cycle.4 Steadily deteriorating underwriting standards has resulted in a preponderance of covenant-lite structures that offer less protection to lenders, while capital structures biased toward senior debt have compressed the debt cushion that in the past helped insulate first-lien investors from losses. All in, it seems likely that recovery rates in the next default cycle are likely to be substantially lower than historical averages, perhaps by as much as 10% to 20%. In such an environment, experience through past default cycles and in loan workouts will prove critical.

Q:
Has the new macroeconomic regime impacted your approach to evaluating companies in your investment universe?

Kimball:
While macro trends can be informative, it’s the Global Value team’s view that a stock’s performance over the long run ultimately is driven by the character of the company and the quality of the people running it. Time and again we’ve seen high-quality organizations thrive in challenging macro environments. This includes businesses in Japan, which has been plagued by deflation and poor demographics for decades, and in Latin America, where economies have faced multiple periods of high inflation and high real interest rates. This is not to say that domicile is meaningless, of course, but we believe a good company—that is, one well positioned within its competitive environment, with a strong balance sheet and quality management—generally can execute in a variety of operating environments.

Jon:
Speaking as a credit investor, the best I can do is get repaid at par at maturity. As a result, my team and I tend to focus our underwriting efforts on an investment’s downside, regardless of current macro conditions. We model a credit’s potential reaction to recession, whether or not one appears likely, and do the same for its interest rate sensitivity. Today, our analysis is particularly concerned with two factors we view as closely related: the resilience of a borrower’s free cash flow and the sustainability of its business model. If there’s no good reason for a company to exist, its cash flows would seem to be particularly vulnerable in a more difficult operating environment.

Jim:
We’re also keeping a sharp eye on the covenants governing our loans. Covenant breaches aren’t good for anyone involved, and it’s important to get ahead of operational challenges before they become acute. We seek to work constructively with borrowers and their private equity sponsors at the first sign of trouble. We try to arrive at a mutually beneficial plan to address any serious issues and promote conditions that enable the borrower to succeed without compromising our interests or those of our investors. Among our considerations are the levers a company may be able to pull to generate incremental liquidity should its free cash flow come under pressure, including tapping its private equity sponsor for a capital injection.

Q:
With rising interest rates squeezing borrowers and tepid back-to-office trends calling demand into question, US commercial real estate (CRE) debt has come under scrutiny. Do you think stress in the CRE space has the potential to bleed into the broader economy and markets?

Jon:
I’ll lead with the punchline: US commercial real estate debt, in my view, is not a systemic risk to the economy or the financial markets.

There are two main reasons for this. First, the magnitude of CRE debt is far less than many appreciate. US CRE debt in aggregate—which includes not only loans backed by office buildings but also multifamily, retail, industrial, hotel and a range of other income-producing properties—comprises less than 10% of bank loans outstanding, and office accounts for only about 16% of total CRE debt.5 Offices in those markets perceived to be particularly vulnerable to delinquency and default represent an even smaller subset. Second, CRE loans typically are written at low loan-to-value ratios, which should provide lenders with additional cushion and support recovery rates.

Kimball:
Because of the diversity Jon noted, it seems likely that any fallout from the challenges currently facing CRE will impact banks idiosyncratically. Smaller regional banks generally have greater exposure to CRE relative to total assets compared to large systemically important bank-holding companies.6 While some smaller banks may face difficulties because of their CRE portfolio’s sector or regional concentration or because they provided loose borrowing terms on high-quality properties that are now being rerated, significant contagion to the financial markets or real economy seems unlikely. At the end of the day, loans written on properties backed by stable cash flows are likely to continue to perform, regardless of property type or location.

Q:
What are you thinking about as we head into 2024 and are another year removed from the era of cheap money?

Kimball:
Taking a page from the Austrian school of economics, I think it’s important for markets and the real economy that capital has a cost. It promotes the efficient allocation of resources and discourages malinvestment and the market distortions than often result. I’m surprised the unwind of a decade-plus of free money hasn’t had broader and larger negative impacts to date, but I don’t think we’re safe from the unintended consequences of this period quite yet. The massive amount of Treasury debt outstanding and increasingly high cost of servicing it is one example of a reckoning that may be looming on the horizon.

Jim:
With capital again having a cost, it seems likely that at some point companies and entire sectors that had depended on cheap money will struggle relative to businesses less reliant on borrowing. Higher prevailing interest rates in an environment that rewards selectivity could result in an attractive vintage year for private credit portfolios with disciplined underwriting standards.

Jon:
The diversity of potential economic outcomes that may result from the Fed’s ongoing efforts to “land” the economy present an interesting challenge. Continued inflation pressures could prompt more aggressive Fed policy and weigh on risk assets, but a soft landing may drive market gains that leave behind the overly risk averse. This kind of uncertainty can stand in the way of investing with conviction, but I think it can also create some really attractive opportunities for active market participants willing to do so, across asset classes.

1. Source: Federal Reserve; data as of June 30, 2023.
2. Source: S&P Global; data as of November 16, 2023.
3. Source: PitchBook; data as of October 31, 2023.
4. Source: S&P Global; data as of December 16, 2023.
5. Source: Mortgage Bankers Association; data as of September 29, 2023.
6. Source: Federal Reserve Bank of St. Louis; data as of November 17, 2023.

The opinions expressed are not necessarily those of the firm. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation to buy, hold or sell or the solicitation or an offer to buy or sell any fund or security.

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